.At the beginning of 2018, I did not expect that trade wars would be a major concern for global markets, and I believe many people shared that view. Simply put, trade is more than a zero-sum game, and it therefore makes sense to preserve international agreements and bodies that support and promote free trade. Unfortunately, that view does not appear to be shared by the administration of US President Donald Trump.
In the administration’s view, the trade issue should be framed as a strategic challenge for the United States, whereby it will seek to address the fact that China has done unreasonably well since it entered the World Trade Organisation (WTO) in 2001 by allegedly following trade practices that for any other country would be wholly unacceptable. Some commentators go as far to suggest that this policy is an inevitable response to longer-term unease around China’s rapid development, and would have happened even without the election of Trump.
I see two ways the situation could play out, depending on policymakers’ motives for the current action. First, it may be that US policy is aimed at pressuring China into abandoning what it alleges are unfair trade practices, whether that’s stealing intellectual property or demanding that US firms enter into joint ventures with local companies. This pressure is aimed at levelling the playing field, and fostering fair competition across companies in both countries. This scenario might not have such a bad outcome, although in the shorter term, achieving it would lead to some friction and market volatility.
The second and more troubling scenario is that this US stance is predicated on seeing China as an emerging cultural, military, political, and economic rival whose progress must be slowed. In particular, there may be a fear of China developing into a high income, high technology superpower that challenges US hegemony. If the priority of the US going forward is to slow Chinese economic development, with the ultimate goal of holding China back from challenging the US in areas such as military technology, then this could be a long, drawn-out, and potentially ugly dispute. If the US wants to curb China as a strategic aim, then perhaps none of these measures on trade are about creating a level playing field - but more about holding back a rival.
Of course, there are other possible outcomes, depending on the motivations of US policymakers, but either of the above scenarios should give investors pause to consider the broader risks. The latter option would be very difficult to undertake, but perhaps US policymakers are indeed willing to pay a price to achieve their strategic aims - and that price would be compromising the relatively stable US-led economic order the world has enjoyed for the past 35 years. A visual representation of this 'grit in the machine' is indicated in the chart below, which shows that levels of trade policy uncertainty are at their highest since pre-Nafta fears in 1994:undefined
Source: Bloomberg; Baker, Bloom & Davis; August 2018. Note: US Categorical Trade Policy Uncertainty Index
This is not insignificant. The markets have grown accustomed to a globalised world where capital can seek out and capture every conceivable cost and product quality advantage, and the medium to long term costs of unwinding this era in the name of nationalism would be considerable. But depending on the intentions behind the current US trade rhetoric towards China, investors will have to discern how protectionist policies might affect the decision making of the corporate sector at large. Without the certainty of the US-led trade and global economic order, it is unclear what companies will do. This issue could be a problem for years to come, and for investors it could take the form of greater volatility, higher risk premiums, and lower growth.
From China’s standpoint, this is an (understandably) sensitive issue. China has no intention of remaining a middle-income country like Brazil or Russia. To achieve the next step in its development, China’s economy needs to move into higher value sectors, including the development and manufacture of electric vehicles, semiconductors and aircraft. State support for these industries is vital. While that might be interpreted as creating an unfair playing field from the US point of view, China sees it as countering the US’s natural advantages, such as the close relationship between its world-leading universities and industrial base.
Trade issues remain an important risk for investors. Whether the consequences of continued tension will be significant enough to have a broad impact on markets remains to be seen. But China and the US come at these issues from very different perspectives, and the potential for misunderstanding is high. That raises the probability of a market-impacting event. There does now appear to be a divergence between the strategic interests of China and the US. Watching the tail risks that flow from that, as well as remaining alert to existing risks, will be important in the coming months.